Banks vs Capital Markets

["ÁÎ×Ó¹â HenryC.K.Liu ¹ù¤l¥ú" <hliu@xxxxxxxxxxxxxx>]

I wrote to the list on February 12 the following:

"It is understandable that banks hate capital markets.
Banks are no longer getting respect.
More analysts are crediting capital markets for the long boom, rather
than banks.

Banks' share of net credit markets, according Fed data on flow of funds,
drop from a peak of over 62% in 1975 to 26% in 1995 and still falling
rapidly, while security markets' share rose from negligible in 1975 to
over 20% in 1995 and still rising rapidly, with insurers and pension
funds taking the rest.

Securitization now stand at over $3 trillion up from $375 billion in
1985.  Asia, including Japan, which still funds its economies mostly
through banks, cannot recover quickly primarily because of an
underdeveloped securitization market."

Last Friday (Feb. 25), the Dow closed below 10,000, a psychological
bench mark from a peak of 11,723 just 4 weeks ago, and 10,000 was
possibly only a transitional barrier.  Some bears have been predicting
for some time (at great pain, I may add) a lack of support until 8,000.
Friday's close was the first bridge of the 10,000 mark in 10 months,
off  14.22% for the year, while the broader S&P 500 lost 9.25%. The
Nasdaq, though not unaffected, is still up 12.81%.

This extraordinary divergence shows more than the different economic
fundamentals of the old and new economy.  It shows the effect of a shift
of importance from banks as a funding intermediary to the capital
markets.  Nasdaq companies rely less on banks for funds and are thus
less affected by Greenspans threats of interest rate hikes.  Greenspan
has been vocal in explaining that his monetary policy moves of rising ff
rates is not specifically targeted towards the stock markets but toward
the unsustainable expansion of the economy as a whole, although at the
same breath, he decries the dangers of the wealth effect if it ever ends
up heavier on the consumption side than on the investment side.
It is a curious position, as most Greenspans positions seem to be: Asset
inflation is good unless it is spent rather than to fuel more asset
inflation.  He continues to restrain demand in favor of supply in a
already overcapacity economy, which has been the points made by
Galbreath, Davidson, Wray, and others scholars on PKT.

The so-called "bifurcated" market indexes clearly indicate that the Fed,
whose sole weapon being monetary measures, has lost control of the new
economy which appears impervious to ST interest rates.  Under such
conditions, the only way the Fed can slow the economy is to overshoot
the interest rate target to rein in a impervious Nasdaq at the peril of
the whole economy.  Interest sensitive stocks have already been battered
badly, including banks and non-bank lenders, such as GE and Amex.

This group : financial services companies, including commercial banks,
brokerage firms and mortgage lenders, has produced some of the biggest
profits in the current bull market.  The combination of rising interest
rates and the hefty leverage on the books of these businesses prove
hazardous to their stock prices. Money center banks and broker dealers
are most vulnerable because they are the most exposed to
interest-rate-related products such as swaps and mortgages

The most popular of all derivative products is the interest rate swap,
which essentially allows participants to make bets on the direction
interest rates will take. According to the Office of the Comptroller of
the Currency, interest rate swaps accounted for three out of four
derivative contracts held by commercial banks at the end of 1999. The
notional value of these swaps totaled almost $25 trillion;  2-3% of that
reflected the banks' true credit risk in these products.

Derivatives of all kinds weigh heavily on banks' capital structures. But
interest rate swaps can be especially toxic when interest rates rise.
And since only a few business economists predicted a jump in rates for
the first half of the year when 1999 began -- in fact, yields have risen
25% -- these institutions now find themselves on the wrong side of an
interest rate gamble.

Moreover, as interest rates rise,  banks' income diminishes from
interest-rate-related businesses like mortgage lending.
Interest-sensitive sources of income will be the revenue disappointments
in 2000, as trading was in 1999.

When Treasury yields were at their highest levels before the Summers LT
debt buybacks 2 weeks ago, rate increases from the Fed seemed consistent
if not rational policy. Stock investors in the old economy did not get
spooked by the expected rising rates. But when the gap between the
Treasury and the Fed has left Telephone bonds at 8.22% while 30 year
treasuries at 6.14% (5.38 year ago), they jumped ship.

Moreover, even if the Nasdaq were to suffer a substantial correction,
its impact on the wealth effect may not be total.  Last week, I was
invited to attend a paid lunch seminar where major investment banks were
pitching to high tech/internet founders and early shareholders to hedge
their winnings to date by signing away their future upsides.  So, for
many high tech swimmers, this amounts to second layer swimming trunks
that they can lose and not risk being caught naked when the tide recedes
suddenly.  It is the financial version of a flat-proved tubeless tire
that can get you to the next gas station or 30 miles (whichever is
closer) in the event of a puncture.  It does not, however, guarantee the
driver the existence of a gas station that has not been forced into
bankruptcy within 30 miles.

There is a near total disconnect between the old and new economies.  The
Dow is falling, according to analysts, because of investor
disappointment over earnings, which will be further impacted adversely
by rising interest rates. Yet the Nasdaq remains impervious to both
interest rate hikes and near-perpetual negative earnings.

Globally, other markets are catching the Wall Street affliction.  Hong
Kong, which traditionally follows US markets because of its currency peg
to the dollar and its exports reliance on US markets, saw the HSI shoot
through 17,000 (coming from a low of 6,600 in August 1997) while the DOW
broke below 9,000, primarily because of a tulip hysteria on Internet
startups and telephone mergers.  One grandmother was reported to have
asked a young broker what the Internet was while she was writing out a 6
figure check to buy the IPO shares of an Internet startup. It is not
likely that the company she was investing would show a positive cash
flow in her life time.

Meanwhile, back in the USA, mutual funds are forced to jettison their
old fashioned balanced portfolios in favor of all tech strategies.
AMG Data Services reported that in the week ending Wednesday, $1.6
billion additional went into high tech funds, $1.2 billion went into
bio-tech, and $1 billion into aggressive growth funds.  S&P 500 linked
funds lost investors.

Now, who are the investors in the old and new economies?  Institutions
such as pension funds and endowment funds, are prevented by law or
internal rules to detach themselves from broadly based portfolios, when
"qualified investors", those with net worth is  over $2 million or more,
depending on SEC definition, are the investors in the new economy.

What Greenspan is doing is to punish the general public by devaluing
their future pension and cash flow, for the sins of the aggressively
investing rich who continues to add to their wealth with Greenspan's
blessing as long as the ill-gained riches are reinvested for more ill
gains.

This is what American economic democracy has come to.

Henry C.K. Liu